The Permian Basin, American energy independence and return on investment
In this blog I return to the topic of the Permian Basin. The research was stimulated by the recent announcement by the USGS of 37 billion barrels of “technically” recoverable oil (my quotes) in the Wolfcamp and Bone Springs of the Delaware Basin - the western half of the Permian, and the subsequent pronouncements on American energy “independence” and “dominance”. Is the USA shaking off its dependency on foreign oil? Is anybody making any money, meaning profit for their investors? Are there any good investment opportunities for the average small-scale investor?
As the charts below show, there has been a significant shift in the top ten oil producers in the world during the last ten years. The US has indeed replaced Saudi Arabia as the number 1 producer. However, number one producer isn’t “dominance”, as the US only accounts for 11% of global production in 2017.
The world’s top ten oil producers in 2007 and in 2017. Units are millions of barrels of oil per day. (Source US EIA).
What about energy “independence”? This appears to be a slightly more complex picture to figure out but it starts with comparing oil consumption with oil production. As the chart below illustrates, the US, like the other top four oil consumers, are net consumers of oil. The US accounts for 20% of the world’s oil consumption - illustrative of several things including America’s dependence on oil. The picture is made worse when the global economics and crude quality types are considered with the US recently becoming a net exporter of oil, not because of being independent or dominant, but price factors and the unsuitability of Permian and other light oil from “shale” for some US refineries or refining products (e.g. distillates) forces traders to export a lot of the US’s new production. Finally, as I will illustrate further below, US shale oil remains vulnerable to oil price volatility. A drop in oil price below $50 makes a lot of shale drilling, including the Permian, uneconomic and indeed the recent price drop in the last couple of months has caused Permian operators to revise their capital budgets for 2019. Ironically, price volatility in the other direction can be unhelpful to operators trying manage narrow margins, as the supply chain tends to use the additional demand as a good reason to ramp their price books up and hence the subsequent decrease in oil price hurts more and more quickly.
The world’s top ten oil consumers in 2016 (2017 data not yet complete). Units are millions of barrels of oil per day. (Source US EIA).
So on its own Permian oil doesn’t look like the solution for American energy independence. I won’t discuss alternative paths to American energy independence in this blog, except to point to previous posts where I argue for oil, and particularly natural gas, together with renewables, carbon sequestration and capture and other measures to be all part of a cohesive and integrated energy transition plan, and by weaning the country off oil dependency, bring energy independence as well as continued reduction in greenhouse gas emissions. Instead I want to take a deeper look at the Permian basin and its growth trajectory.
Growth in US shale production. (Source: ShaleProfile)
Gross daily oil production in the Midland and Delaware basins by operator (Source: DrillingInfo).
As the chart above illustrates, following a two and a half year decline due to the oil price crash, oil (and gas) production from US shale has grown at an amazing rate, with the growth largely driven by the Permian Basin. The chart to the left illustrates the top 40 operators contributing to that the production growth. Seven of the firms on the list are privately held, typically as portfolio companies in private equity funds, and hence the domain of accredited investors who can afford the minimum subscriptions. The super-majors are present as well including BP back again in the Permian through the purchase of BHP Billiton Petroleum’s shale assets. The large independents such as Apache and Anadarko are also active. Top of the producer list is Concho Resources Inc, one of a number of Permian-only players. I am going to concentrate on this group to test the Permian phenomenon for financial performance and durability, as well as investment opportunities, with a particular focus on the four biggest companies that have been growing their position in the Permian through acquisitions, large and small, and hence look like a good test of how consolidation might drive Permian economics. As several have argued (see for example Kimmeridge Energy), consolidation involving merger of the smaller companies is more likely to yield value to investors because of several economies of scale, and hence these larger firms might be expected to perform better financially. In the charts below I plot some basic measures of performance of the seven companies. I intend to look in more detail at the other companies involved in future articles. The net income per barrel chart on the left shows that most of the companies have managed to post a profit since the oil price recovery in 2017. However the margins are skinny compared to recorded and potential future oil price swings. For example, I don’t expect any of these companies to post a profit from the 4th quarter 2018 as the average oil price has dropped $18/bo since 3Q. Nevertheless several of these companies are priced seemingly with the expectation of earnings growth. Two of the firms, the two smallest in this group, already look in need of salvation.
Recent income performance and key financial metrics of the three top independent producers in the Permian basin. Size of the bubble in the right hand chart is scaled to reported 2018 3Q net production in barrels oil equivalent. (Sources, Company reports, SEC filings and Yahoo Fiance).
The next series of charts plot out the income statements of each of the top four in terms of income/loss per barrel oil equivalent sold. This reveals some interesting clues to the skinny margins. Firstly, the realizations compared to average WTI oil price are quite a bit lower, even allowing for gas mix. This reflects the well-reported issue of a bottleneck on oil export out of the Permian to markets such as on the Gulf Coast. This problem is being tackled by the midstream companies with additional pipeline capacity expected in 2019 and 2020. A side effect, which has had substantial impact on several companies involved in the Permian, is the volatility in the price spread in oil priced at Midland and at Cushing. Several companies have lost on some big derivative books, even the mighty trading arm of BP suffered a small loss associated with this problem in 2Q 2018. In this group, all have been losing on derivatives during the last year, but Concho’s $625million loss on derivatives in 3Q does catch attention, shaving $23.70/BOE off their margin! These issues should be alleviated in the next 24 months or so, but a lot of oil will be produced in this challenging environment in the mean time.
2018 3rd quarter income statement analysis per barrel oil equivalent for top four Permian-only operators. (Source: company SEC filings)
Turning to more traditional challenges to oil producers margins, the three biggest bricks of cost are Depreciation, Depletion and Amortization (DD&A), production costs (including lease operating expenses, production taxes, gathering, transport and other midstream services and a few other odds and end), and General and Administration (G&A). These brackets conspire to keep net income per barrel to at best about $15/BOE through the first three quarters of 2018. It’s also clear from company presentations that they recognize the challenge and acting to improve margins. DD&A reflects capital associated with acquisition and development of the assets depreciating overtime, as well as depletion of value associated with production of resource. It will be interesting to see the effect on reserve valuations at year end given the low oil price right now, but aside from that worry, the main action companies can take is to ensure that the capital efficiency of new capital sunk into the business continually improves. Continuous improvement on completion size and efficiency appears to be occurring, and this helps capital efficiency both in terms of productivity and reserves “booked”. Several companies illustrate some large-scale actions on large drilling pads with multiple wells planned. This is also an example of where big is probably better, with larger companies able to command continuous drilling and completion resources at better prices from the contractors. There are confident forecasts of “breakeven” costs per new barrel coming down further to well below $50/bo, but this will have to be sustained to offset legacy capital already deployed in the business.
Production costs at less than $10/BOE are pretty good, but it remains a big slice off the profit margin and needs to be the object of searing cost efficiency management. Again bigger is probably better in this area as well, as should G&A.
As I’ve argued before, I would like to see more out of the box thinking and action applied to upstream businesses and fervently believe that much of this thinking and approach is not new at all and comes from someone else’s box! The multiple and repeated activities of drilling, completion and subsequent well management present huge opportunity to “operational excellence” culture and systems, including Lean and 6 sigma from the automobile and other manufacturing industries. Friends who know about automation, big data utilization and plant management, remain appalled at just how little the upstream industry has yet to pick up on these technologies and ways of working.
So the Permian shale oil growth is certainly phenomenal, but it's not going to bring American energy independence on its own, and the basin and the firms operating there remain vulnerable to oil prices below $50/bo. A mindset shift from focusing on margin more than volume is the potential solution for both more profitable businesses and continued growth of a national energy resource.
I don’t have stock in any of the companies mentioned except for BP in which I still have a concentrated position, a legacy of a very enjoyable 25 year career with the company. I certainly have my eye on several companies so I can dilute my BP position, but remind myself and the reader of the usual risks of investing in the stock market, particularly in the volatile and uncertain context we are currently experiencing.